Introduction to Behavioral

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I N T R O D U C T I O N

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  As they entered the second year in the job, who do you think was happier?

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   As they entered the second year in the job, each received a job offer from another 

fi rm. Who do you think was more likely to leave her present position for another job?

Of all the respondents 71% thought that Ann was better off, while 29% thought that 

Barbara was better off. However, only 36% thought Ann was happier, while 64% thought 

that Barbara was happier. In the same vein, 65% thought that Ann was more likely to 

leave her job, with only 35% thinking Barbara was more likely to leave. 

A contracts-related question was designed to test people’s preferences for indexing 

contracts for future payment to infl ation. From a seller’s viewpoint this would be 

preferred by decision-makers who were risk-averse in real terms, while those who were 

risk-averse in nominal terms would prefer to fi x the price now. The situation featured 

computer systems currently priced at $1000; sellers could either fi x the price in two 

years at $1200, or link the price to infl ation, which was expected to amount to 20% 

over the two years. The options were framed fi rst of all in real terms (based on 1991 as 

the current year) as follows:

Contract A   You agree to sell the computer systems (in 1993) at $1200 a 

piece, no matter what the price of computer systems is at that 

time. Thus, if infl ation is below 20% you will be getting more than 

the 1993 price; whereas, if infl ation exceeds 20% you will be 

getting less than the 1993 price. Because you have agreed on a 

fi xed price your profi t level will depend on the rate of infl ation.

Contract B   You agree to sell the computer systems at 1993’s price. Thus if 

infl ation exceeds 20% you will be paid more than $1200, and if 

infl ation is below 20%, you will be paid less than $1200. Because 

both production costs and prices are tied to the rate of infl ation, 

your ‘real’ profi t will remain essentially the same regardless of the 

rate of infl ation.

When the options of fi xing the nominal price and index-linking were framed as above 

in real terms, a large majority of the respondents (81%) favored the option of index-

linking, indicating risk-aversion in real terms. However, when the equivalent options 

were framed in nominal terms, as shown below, a different result was obtained:

Contract C   You agree to sell the computer systems (in 1993) at $1200 a 

piece, no matter what the price of computer systems is at the 

time.

Contract D   You agree to sell the computer systems at 1993’s price. Thus 

instead of selling at $1200 for sure, you will be paid more if 

infl ation exceeds 20%, and less if infl ation is below 20%.

In this case a much smaller majority (51%) favored the index-linking option, which now 

seemed more risky. 

 

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When the contract situation was reversed, so that respondents were now in a buying 

situation, it was also found that the framing of the options affected the responses. 

Once again respondents were risk-averse in nominal terms when the options were 

framed in nominal terms and risk-averse in real terms when the options were framed in 

real terms.

Issues

The discussion of money illusion raises a number of important issues in behavioral 

economics. Some of these are similar to the previous case:

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 Methodology

 

Economists have criticized the validity of the SDT results on two main grounds. First, 

they have doubts about the questionnaire methodology, suspecting that there may 

be considerable differences between what people say they might do in a hypothetical 

situation and what they would actually do in the real world when motivated by 

economic incentives. Second, they point out that it is not suffi cient to show money 

illusion at the level of individual behavior; it must also be present at the aggregate 

level in order to have real economic signifi cance. Individual differences may cancel 

each other out, thus resulting in no overall economic effect.

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 Rationality

 

It is usually argued that money illusion is not rational at the level of the individual. 

However, it is notable from the SDT study that the majority of the respondents realized 

that Ann was better off in economic terms, even though a majority thought that Barbara 

was happier. This perceived decoupling of absolute economic welfare from happiness 

is not necessarily irrational, and will be discussed further in Chapter 3. Furthermore, it 

may well happen that a majority of individuals do not themselves suffer from money 

illusion at the individual level, but may believe that others do. Therefore, in order to 

understand the existence of money illusion at the aggregate level, it is necessary to 

examine the strategic interaction of individuals in the economy.

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 Mental 

accounting 

 

It is notable that the SDT study not only attempts to test for money illusion in a 

descriptive sense, it also goes some way towards trying to explain its existence 

in psychological terms. This involves general aspects of mental accounting, more 

specifi cally the theory of multiple representations. These aspects are discussed 

in detail in Chapter 6, but at this stage we can outline the theory by saying 

that it proposes that people tend to form not just a single mental or cognitive 

representation of information, but several simultaneously. Thus we may form both 

a nominal and a real mental representation of different options, but, depending on 

how they are framed, one or the other may be salient. Thus the concepts of framing 

effects and saliency are important. The SDT study maintains that normally the 

nominal representation tends to be salient, since it is cognitively easier to handle, 

demanding less information. This therefore tends to give rise to money illusion. 

Later on we will see that there are similarities here with types of optical illusion.

 

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